Keynes and the crisis

I am inclined to agree with Robert Skidelsky that the present global economic crisis has decisively resurrected Keynesianism into the mainstream of economic thinking, displacing the neo-classical theories of Friedrich Hayek, Milton Friedman and the Chicago School.

While the economy was on a sustained boom, it was easy to forget the lessons of the Great Depression, and write the obituary for Government intervention. The ideological thrust of Thatcherism and Reaganism, institutionalized through the Washington Consensus and its instruments like the World Bank, IMF and WTO, clearly assumed markets as self correcting and saw limited role for governments. The pervading belief was that boom-bust cycles must be caused by outside 'shocks' - wars, revolutions, and above all political interference. The financial markets were considered efficient, accurately pricing all the risks in all the trades at each moment in time. As Skidelsky says, greed, ignorance, euphoria, panic, herd behavior, predation, financial skulduggery and politics, were all considered exogenous.

It was even argued that the spectacular technological progress of recent years had created a "goldilocks" (not-too-hot and not-too-cold) economy, that attenuated and smoothed the business cycle. The global "savings glut", China's emergence as the "cheap factory of the world", American consumers propensity to spend as there was no tomorrow, all of them fueled by the historically unique combination of low interest rates, inflation, and unemployment rates, more or less explained this extraordinary period of boom.

But the events of the past few months have shaken all these entrenched beliefs to the core, marginalized markets and brought governments back to the center of the debate on economic issues. As Skidelsky argues the present crisis has shown that market mechanism are not always rational and there may be no automatic barrier to the slide into depression, unless a government intervenes to offset extreme reluctance to lend by huge injections of cash into the economy. The importance of the Keynesian "automatic stabilizers" - the movement of the budget into deficit or surplus as the economy slowed or speeded up - assume importance for both Wall Street and Main Street.

Keynes had held that during times of economic turbulence, governments should vary taxes and spending to offset any tendency for inflation to rise or output to fall. Therefore, a depressed economy might remain trapped for a long time in a state of "underemployment equilibrium", from where it could be rescued only by a massive external shock. The surge in government spending to support the World War II effort, was the external shock that took the US economy out of the 1930s depression.

Skidelsky contends that Monetarism had failed to appreciate the important fact that price level is not a leading, but a lagging, indicator. Therefore asset bubbles can coexist with a stable price level, even while the rest of the economy is starting to slide into depression.

Skidelsky writes that Keynes had argued that during times of asset bubbles, "Money was being switched from production to speculation. The rich were getting very much richer, while the incomes of the rest were stagnating. "Profit inflation," fueled by collateralized debt, went together with an "income deflation." Share prices were being driven up to dizzying heights even as farmers were finding it harder to service agricultural mortgages. Every financial crash is different in detail - today's started in the banking system, not the stock market - but the anatomy of all is surprisingly similar: A speculative frenzy, triggered by some technical innovation such as mortgage-backed securities, that collapses when reality - in the form of more sober valuations - kicks in."

Chris Dillow, as always is more nuanced, and feels that Keynes may not be the ideal place to find explanation for the present crisis. The financial market, rather than real economy, origins of the crisis, and the impossibility of governments to predict and thereby prevent recessions, means Keynesian explanations may not work well. He writes, "please don’t think Keynes thought booms and slumps could be prevented merely by pulling fiscal and monetary policy levers."

But once recessions have arrived, as is the case now, the only option to smooth over or attenuate the impact of the downturn is by "pulling fiscal and monetary policy levers"!

Update 1
Edmund Phelps makes an interesting distinction between a drop in asset prices springing from monetary causes – an exogenous, or autonomous, increase in the demand for money – and one springing from causes having nothing to do with supply and demand for money – say, diminished expectations about future returns on business assets or houses. Keynes had argued that all such phenomenon could be solved by lossening monetary policy.

The former phenomenon could be solved by monetary means: the central bank could boost the money supply (by purchasing public debt, say), which would drive asset prices back up without driving up other prices and wages equally in a pointless spiral. But Phelps feels that events like the recent collapse of speculation on houses, are a non-monetary phenomenon - there has to be a drop of the money price of (a basket of) houses relative to the money price of (a basket of) consumer goods - and hence cannot be addressed by the traditional monetary loosening.

He also feels that the Keynesian contention that consumer demand would drive employment (an increase in demand encourages companies to raise production and hire more workers) may not hold in an open economy, where the fiscal stimulus may only go abroad. In the global economy, increased consumer demand would ultimately do little more than raise interest rates, thus setting off declines in real asset prices, investment and real wages.

Update 1
Keynes message to the President of US - spend, spend, spend!

Update 2
Martin Wolf argues that Keynes genius, especially in a world where the debate had crystallized into a battle between the left and right, state and market, command economy and free market, the need of the hour is to approach an economic system not as a morality play but as a technical challenge - preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds.